ECONOMIC VIEW

ECONOMIC VIEW; Spotted: Evidence That Tax Cut Worked

By Edmund L. Andrews

Published: October 19, 2003

WASHINGTON—
IS it time for the skeptics to admit they were wrong about President Bush's tax cuts?

To the surprise of many naysayers, economic data from the past several months suggests that the $350 billion tax-cut package may indeed have jolted the economy.

Congress approved the tax-cutting bill in late May, and consumer spending jumped at annualized rates of more than 12 percent in July and August. Business investment climbed modestly, and manufacturing activity is picking up as well.

Based largely on the unexpected strength in consumer spending, economists believe the economy grew at an annual rate of at least 6 percent in the quarter that ended Sept. 30.

Edward McKelvey, an economist at Goldman Sachs who was extremely dubious about the Bush tax cuts, now says they played a central role in the new expansion. He estimates that consumers spent as much as three-quarters of the tax relief from the summer, which included reductions in federal withholding taxes and checks of $400 per child that were part of an expanded child tax credit for families.

''They definitely had a stronger impact on spending than we anticipated,'' Mr. McKelvey said, referring to the tax cuts.

The evidence is still circumstantial. There is little empirical information on whether people saved or spent their tax rebates, and it is possible that the summer spending spree stemmed more from low interest rates than lower taxes.

Indeed, home mortgage rates dropped to their lowest levels of the year in mid-June, mainly because bond investors incorrectly assumed that the Federal Reserve was about to drive rates lower to minimize the risk of a broad-based deflation in prices.

That drop in mortgage rates sparked another boom in mortgage refinancing, which usually feeds consumer spending because homeowners often take some cash out of the equity in their homes.

Still, most analysts say the timing and strength of consumer spending cannot be explained without referring to the tax cuts. Mortgage refinancings, for example, take time to process and people often use the cash they extract from their homes for home improvements. What happened in July and August, by contrast, was sharp and sudden.

Except for their tax cuts, moreover, Americans did not have extra money on their hands. Unemployment was above 6 percent and the economy actually lost 142,000 jobs in July and August, and gained 57,000 in September. With the labor market weak, hourly wages and salaries showed almost no improvement.

That leaves tax cuts, which increased disposable income and, through the $400-per-child checks, put a tangible amount of money straight into people's pockets.

What has surprised the skeptics is that people may have spent so much.

Joel Slemrod, director of the Office of Tax Policy Research at the University of Michigan, said his surveys and other polls suggest that people spent only about a third of their tax relief after the 2001 tax cuts and wanted to save the rest, and this year's response appears to be similar. ''The preliminary evidence suggests that the marginal propensity to consume is about the same this time,'' he said.

Part of the discrepancy may simply be the difference between what people think they should do with their extra cash and what they actually do with it. It may also be the case that much of the upfront tax relief, the $400 checks, was concentrated on households that are most likely to be in urgent need of extra cash.

WHATEVER the explanation, the question is whether strong economic growth can be sustained.

The impact of the tax cuts is already fading, most economists believe. Even though the lower tax rates will continue, the economic jolt comes from the initial cut. After that, the economy simply grows in line with the overall rise in wealth.

There are already signs that the kick from this year's tax cuts may be fading. The Commerce Department reported last week that retail sales in September were 0.2 percent lower than in August. Excluding automobiles, retail sales climbed 0.3 percent. That is still growth, but less than one-third the pace in July and August.

Even optimistic forecasters predict that economic growth will slow in the months ahead. For President Bush, who is being pilloried by Democrats for an unemployment rate that remains above 6 percent, the question is whether business spending will pick up even if consumers feel winded.

If businesses fail to take up the slack through spending and hiring, the mood among voters could easily be quite sour by next fall.

Chart: ''Spending Spurt'' Total retail and food services sales, seasonally adjusted. Graph tracks total retail and food services sales, measured in billions, from January to September. (Source by Commerce Department)